Question

1. You are given the following data regarding a Latin American country     currency=50 billion                                                                                                                        demand deposits=100 billion                                                                                                       
   bank reserves=20 billion                                                                                                                   
   a. Define and calculate the following                                                                                          
   -monetary base                                                                                                                                     
   -money supply                                                                                         
   -money multiplier                                                                                                                               
   b. Suppose during the month of May country’s central bank gains international resererves by an amount equal 10 billion. Assuming Central Bank credit remains unchanged, what will be impact the gain in international reserves on:monetary base, money supply                                                                           
   c. The goverment wants to keep the money supply unchanged in spite of gain of reserves . what offeseting operation could it engage in?      

Answer 1

Reserve ratio (rr) = Reserves (R) / Deposits (D) = 20 / 100 = 0.2

Currency deposit ratio (cr) = Currency (C) / Deposit (D) = 50 / 100 = 0.5

(a)

(i) Monetary base (MB) is the sum of currency and reserves, and has the value of

MB ($ billion) = 50 + 20 = 70

(ii) Money supply (MS) is the total stock of money in the economy at a given point of time, and has the value of

MS ($ billion) = C + D = 50 + 100 = 150

(iii) Money multiplier (MM) is the ratio of increase (decrease) in money supply to an increase (decrease) in monetary base.

MM = (1 + cr) / (cr + rr) = (1 + 0.5) / (0.5 + 0.2) = 1.5 / 0.7 = 2.14

(b)

(i) Increase in reserves will increase MB by $10 billion.

(ii) Increase in MS ($ billion) = Increase in MB x MM = 10 x 2.14 = 21.4

(c)

Money supply can be decreased by Central Bank, by using contractionary monetary policy to reduce domestic money supply. This can be done by open market sale of government securities, or by increasing discount rate or by increasing required reserves ratio.